Health Savings Accounts: Classical Model
New topic 2015-09-03 22:42:59 description
Let's see how short and succinct we can make it. Our task is to take the maximum amount of savings we could possibly ask the public to accumulate, invest it more or less on autopilot, and see if it can generate enough money to pay for what we assume will be health costs a century from now. Some would say that's a fool's errand, but let's see what we can do.
We start with an assumption the average person can save $3350 per year from age 21 to age 66; that's $150,750, total, the most anyone can invest in an HSA. The actuaries at Michigan Blue Cross, verified by Medicare, estimate average lifetime healthcare costs to be $350,000. Some people state you can stop talking, right there, because that's too much money. Please be patient, we will address indigency later. For simplicity, we wish to reduce the question to whether we could turn $150,750 into $350,000 in forty-five years with compound interest at reasonable rates. The answer is yes. We can't predict whether those future predictions of costs are accurate, but if accurate, they can be achieved. We assume two things:
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Indigents. We assume there will be no more indigents than at present. Can the government afford to subsidize them in this model? The answer is Yes, but its present commitment is in another direction, so it isn't entirely likely, very soon.
Outliving Your Income. We assume some people will use up their savings. If the average life expectancy, which is now 83, holds its present course, we assume this model can cope with it, even if the average life expectancy grows to be 93 in the next century. The arithmetic is quite favorable, but unfortunately, we don't know what new costs will be added in the meantime. Assuming there are some, we aren't counting them, so predictions about the future all contain this flaw.
We assume some other things, mentioned as we go along, essentially coming to the conclusion the model will produce a result which falls between the top and bottom curves in the graph. Please note the narrow range of variation in the early years and the widening upward range in later years. In particular, notice how a 3% (inflation) rate tends to stay flat well past any reasonable life expectancy, while more likely, investment income returns start to rise at age 60, and even sooner as the rate approaches 9% net of inflation. That seems to be a "sweet spot" the economy has discovered for itself in two hundred years of exploration.
We assume the equity stock market will follow the paths it followed since the Industrial Revolution. That is, it will produce an average of 12% gross return, with 3% of that eaten up by inflation, or 9% net of inflation. We then estimate our present conservative projections at producing at least 6.5% after costs, out of the remaining 9%. Dismissing inflation, we assume the stock market will operate between a 2% real return, and 9.5% real after inflation, leaving a 3.5% "cushion" for contingencies. When the Industrial Revolution ends, these basics may also change. We have a decade or so to try to get the investor's returns up closer to 8% safe level. And meanwhile, we must try to remain prepared for a bleak and bad depression, a "black swan", on average every 28 years, but individually unpredictable. In the meantime, we aspire eventually to pay for 100% of healthcare expenses, but promise to pay only a quarter of that. And finally, we assume medical care will change so much during the next century, that our calculations will need to be totally revised, long before then, with a so-called mid-course correction. With the understanding, that anything which pushes outside of the accompanying graph will have an obvious explanation, we assume future managers will make appropriate adjustments.
Single Premium Investment/Look carefully at the graph. It makes an unfamiliar assumption. It assumes a newborn baby started a Health Savings Account at birth, deposited $500 in it, and didn't touch the account again until he died. It is our assumption the average person could do that, perhaps with a stretch, and our further assumption that the government could do the same for indigent babies. There are times when neither the government nor many middle-class people could manage the necessary expenditures, but we set the value of $500 at birth as an extreme limit of what we think they both could do, on average most of the time. It's a number which is easily changed if the economy varies from our projection.
Let's dramatize the point we're making on a totally different scale, by temporarily appointing Warren Buffett as its role model. According to a story in the Wall Street Journal by columnist Morgan Housel, this is the way the best investor in history made his money. At the age of eighty-four, his personal wealth was $73 billion. Of that, he made $70 billion after the age of sixty. Some might retort, the trick is to make the first $3 billion by the age of sixty, but a more civil underlying moral is that compound interest really starts to work toward the end of life.
Just take another look at that graph; the particular power of compound interest works as efficiently with $500 as with $3 billion. It starts earlier with higher interest rates, in this case, age 40 at 12%, compared with age 85 at 5%, Mr. Buffett's numbers. Obviously, it pays to start early and to get higher interest rates if you can do it safely. And conversely, it's a bad idea to spend or squander your savings while you are young. Our preferred method is to raise the interest rate by reducing the attrition of middle-men, in the approach mentioned earlier. You might not reach 12%, but you have a fair chance of reaching 9% if you allow yourself fifteen years to work on it. In the meantime, be satisfied with less than 100% coverage by this method.
More seriously, why else did we pick this way to depict the future? Because at age 66, when Medicare takes over, all of the plausible curves have reached a point where they could match Medicare's expenditures, indefinitely. If Medicare went broke, or was otherwise unacceptable for some reason, liquifying the account would produce a sum matching Medicare's present rate of expenditure. And finally, the numbers become so astronomical at the far end, it seems entirely reasonable to transfer part of the account to a grandchild's account. That trick alone should greatly reduce the problem, and add 21 years for compound interest to do it. As we will see in a coming section, paying childhood health expenses in advance solves some otherwise difficult issues.